Help me answer Senate committee’s questions about Bitcoin

Over a month ago I testified at the Senate Homeland Security and Governmental Affairs Committee hearing on Bitcoin. I’ve been asked by the committee to submit answers to additional questions, and I thought I’d try to tap into the Bitcoin community’s wisdom by posting here the questions and my draft answers and inviting you to post in the comments any suggestions you might have. I’d especially appreciate examples of innovative uses of Bitcoin or interesting potential business cases. Thanks for your help!

Post-Hearing Questions for the Record

Submitted to Jerry Brito

From Senator Thomas R. Carper

“Beyond Silk Road: Potential Risks, Threats, and Promises of Virtual Currencies”

November 18, 2013

1. Overall, how would you assess the federal government’s activities thus far regarding virtual currencies and in what areas do you believe more work needs to be done?

The federal government’s approach to virtual currencies thus far has been understandably cautious.

On the anti-money-laundering and terrorist-financing front, FinCEN has issued guidance that adequately addresses virtual currencies, and it is heartening to see recent reports that the agency is clarifying for entrepreneur and consumers how they plan to apply that guidance. Additionally, with the tools already at their disposal, law enforcement has also successfully taken down the Silk Road online black market, as well as Liberty Reserve, a centralized digital currency favored by online criminals and responsible for laundering billions of dollars.

On the consumer protection front, state financial regulators are currently developing guidelines for the licensing of money transmitters, which are meant to ensure that such businesses are well-run and adequately capitalized. As noted in a question below, however, virtual currencies like Bitcoin are still not in use by very many consumers, and those who do use them likely understand the risks involved, giving regulators the luxury of seeing how the market develops and whether any problems arise before intervening.

One area where more guidance may be necessary is tax compliance. The IRS has indicated that it is working on guidance related to virtual currencies. Clear and simple rules for the tax treatment of virtual currency capital gains and other tax questions would be welcome.

2. Do you believe virtual currencies, including Bitcoin, fit into our current legal and regulatory framework? Do you see any gaps in our statutes and regulations regarding virtual currencies? Which agencies do you believe need to be at the forefront of the federal government’s work on virtual currencies?

To date we have seen that regulators have been able to apply existing law to virtual currencies. In the future, there may be situations in which existing law may not be able to fully account for virtual currencies. For example, to the extent we may some day see a Bitcoin futures market, the Commodities Future Trading Commission may want to exercise its authority over “foreign-exchange forwards” or “foreign-exchange swaps.” However, it would be difficult to justify that virtual currencies are “foreign” currency, which Congress did not define in Commodity Exchange Act presumably because the meaning was obvious at the time. That said, the CFTC would have no problem treating bitcoins as commodities, since “commodity” is defined very broadly by the Act. What this suggests is that rather than attempt to predict how current law may not become incompatible with virtual currency use, a better approach may be to wait for actual “cases and controversies” to arise and to intervene only if regulators cannot apply existing law. To do otherwise may invite unintended consequences or simply waste time and resources.

3. As I understand things, currently there is still a relatively very small group of people that use Bitcoin. That being the case, the full scope of the ramifications of the use of Bitcoin remains to be seen.

a. Can you share with us some examples of uses that might have a positive impact for consumers or the broader economy? What are some of the promises of this new technology, as you see them?

b. What kinds of businesses and opportunities might emerge around Bitcoin if the currency continues to grow?

I would refer you to pages 10 – 20 of Bitcoin: A Primer for Policymakers in which my colleague Andrea Castillo and I detail the ways Bitcoin may positively affect the economy, as well as the business opportunities it presents.

4. Since its introduction in 2008, Bitcoin has experienced a number of significant price swings. For example, in 2013, the price per Bitcoin fell from $266 in early April to $50 in late April, but today is hovering around $1000.

a. What factors have contributed to this volatility?

There are at least three reasons that the price of Bitcoin fluctuates so wildly. First, the total value of all outstanding bitcoins is still relatively low. This means that even a small absolute increase in interest in Bitcoin can send prices soaring.

Second, a large fraction of the existing stock of bitcoins seem, for now, to be held as a long-term investment. This means that the market is not very liquid.

Finally, when there is a change in the demand for Bitcoin, the supply of Bitcoin cannot adjust to accommodate it, so all of the adjustment has to happen in the price, rather than in the quantity. This effect may be somewhat offset for now by the fact that many bitcoins are held as investments, but it means that Bitcoin is likely to be relatively volatile even if people stop holding bitcoins as investments.

b. For those companies who are trying to build businesses around this technology, doesn’t this volatility concern you? What can be done so the price is not so volatile?

Merchants that accept payment in bitcoins and companies trying to build businesses around the protocol no doubt already take the volatility into consideration. For example, merchants that accept bitcoins often use a payment services like BitPay, which deposit dollars into merchant accounts on a daily basis, and companies like BitPay hedge against currency volatility. That said, as more and more consumers begin to use Bitcoin, the market will become more liquid and volatility should subside. Additionally, the development of a bitcoin futures market may also help stabilize the currency. Regulators can help combat volatility by allowing such a market to develop.

5. Most of the recent research and media coverage on virtual currencies has focused on Bitcoin. Are there other virtual currencies that we should be paying attention to?

It is important to keep in mind the difference between centralized and decentralized digital currencies. Centralized currencies like the defunct Liberty Reserve are of greater concern to law enforcement, as Special Agent Edward Lowery explained at the hearing. As for decentralized digital currencies, it is not surprising that Bitcoin has earned the lion’s share of attention since it is the first ever decentralized currency as well as the largest. Indeed, the economy of the next largest decentralized digital currency—Litecoin—is less than one-tenth that of Bitcoin. Competing decentralized currencies are very important, especially as they develop technical innovations, but the regulatory and law enforcement issues they raise are essentially the same as Bitcoin.

6. The point has been made to me that the way to see Bitcoin and virtual currencies today is a bit like we saw email or the internet itself 20 years ago. At the time, we thought email might replace mail but it was sort of complicated and difficult to work unless you were more technically minded. Obviously as the technology matured it became easier to use and more widely adopted and it’s changed the way we communicate in fundamental ways. With that said, if you could hazard a guess, what do you see for Bitcoin 20 years from now?

Email is a good analogy, but a better one might be the World Wide Web. As Mike Hearn, an engineer at Google who serves as one of Bitcoin’s core developers, says, “The Web started out as scientists simply showing documents to each other. You could link documents and embed images, but the true potential of the Web really came when these pages became interactive and started gaining more and more features allowing people to build things like Facebook or online shops. Those things are not documents, and now probably half the time people use the Web they aren’t really interacting with documents; they are actually using applications.”

Unlike email, the Web is a platform, which means that it can be programmed to be just about anything. Bitcoin is similarly a platform that can be programmed. As a result, it’s difficult to predict what developers and entrepreneurs allowed to freely innovate may come up with. However, some innovations that Bitcoin may make possible include micropayments, smart property, decentralized assurance contracts, and competitive arbitration services.

7. What can we as policymakers and legislators be doing to encourage innovation by good actors interested in being involved in the virtual currency space?

As I said in my testimony, policymakers’ first imperative should be to do no harm. Bitcoin and other decentralized digital currencies are an experiment, just as the wider Internet once was. The Internet has become the amazing engine of innovation and economic prosperity because it has largely been left alone by regulators. This was a deliberate policy articulated by President Clinton’s chief policy counsel Ira Magaziner, who was in charge of crafting the administration’s Framework for Global Electronic Commerce in July 1997. Its recommendations read in part:

The private sector should lead. The Internet should develop as a market driven arena not a regulated industry. Even where collective action is necessary, governments should encourage industry self-regulation and private sector leadership where possible. Governments should avoid undue restrictions on electronic commerce. In general, parties should be able to enter into legitimate agreements to buy and sell products and services across the Internet with minimal government involvement or intervention. Governments should refrain from imposing new and unnecessary regulations, bureaucratic procedures or new taxes and tariffs on commercial activities that take place via the Internet. Where governmental involvement is needed, its aim should be to support and enforce a predictable, minimalist, consistent and simple legal environment for commerce. Where government intervention is necessary, its role should be to ensure competition, protect intellectual property and privacy, prevent fraud, foster transparency, and facilitate dispute resolution, not to regulate. Governments should recognize the unique qualities of the Internet. The genius and explosive success of the Internet can be attributed in part to its decentralized nature and to its tradition of bottom-up governance. Accordingly, the regulatory frameworks established over the past 60 years for telecommunication, radio and television may not fit the Internet. Existing laws and regulations that may hinder electronic commerce should be reviewed and revised or eliminated to reflect the needs of the new electronic age. Electronic commerce on the Internet should be facilitated on a global basis. The Internet is a global marketplace. The legal framework supporting commercial transactions should be consistent and predictable regardless of the jurisdiction in which a particular buyer and seller reside.

The same principles should apply to Bitcoin today. If there is one thing policymakers could do today to encourage innovation by good actors in the Bitcoin space it is to signal to the traditional financial sector—especially in banking—that while Bitcoin presents some challenges, it is nothing to be feared, and they will not be penalized by regulators for servicing, working with, and even investing in Bitcoin-related businesses.