Virtual Currency: Bitcoin - Risk and Challenges

Malcolm Rowe Director

PwC

Financial Services Regulatory Practice

917-443-2059

Malcolm.rowe@us.pwc.com

What is Bitcoin?

• Digital Currency?

• Payment System?

• Transactional Platform?

• Money, Commodity, Security … or something completely new?

What is Bitcoin?

Bitcoin is a digital, decentralized currency that is created, held, and used online

“A digital currency is, generally, a digital unit of exchange that is not backed by a government issued legal tender.” – U.S. Government Accountability Office

What is a Digital Currency ?

What is Bitcoin?

• The Basics of Bitcoin:

- An open source, digital currency

- Not backed by any government (decentralized)

- Created and maintained by a vast network of computers

- Capped at 21 million bitcoins

- The founder is a mysterious individual or group of individuals known as “Satoshi Nakamoto”

- Currently the conversion rate is around 1 BTC = $404, but there has been substantial volatility

What is Bitcoin?

• Created & Maintained by a community of computers...

- Millions of computers “mine” bitcoin by solving complex math problems

- They also track and certify all bitcoin transactions in a giant ledger called 'the block chain'

The Future of Bitcoin

Venture capitalists investing heavily in Bitcoin companies:

• In December 2013, Coinbase (a SF-based bitcoin startup) raised $25 million in a round led by Andreessen Horowitz

• In March 2014, Circle (a Boston-based bitcoin startup) raised $17 million in a round led Breyer Capital, Accel Partners, and others

• In May 2014, Bitpay (an Atlana-based bitcoin startup) raised $30 million in a round led by Richard Branson and Jerry Yang

• In July 2014, Xapo (a Palo Alto-based bitcoin startup) raised $40 million in a round led by Index Ventures and Greylock Partners.

The Future of Bitcoin

Bitcoins are gaining traction with merchants and companies looking to reduce costs associated with credit cards

• Dell – July 2014

• Expedia – June 2014

• Overstock.com – Jan 2014

The Future of Bitcoin

Merchants Should Love It

• Easy to receive as payment

• Low Fees

• Global customer base

• No chargebacks / Reduce Fraud

• No PCI Compliance

• What does it mean to accept BTC today?

The Future of Bitcoin

The Consumer Side

• No Chargebacks – Loss of Protections?

• Conversion Costs

• Loss of Credit Card Benefits

Legal Status of Bitcoin

Bitcoin has different legal status for different legal purposes

• Securities Laws

• AML/BSA

• Taxation

• Commodities

Legal Status of Bitcoin

Bitcoin has different legal status for different legal purposes

• Court Decisions

– SEC v. Shavers, Case No. 4:13-CV-416, Memorandum Opinion Re the Court’s Subject Matter Jurisdiction (EDTX 8/6/13): “Bitcoin is a currency or form of money, and investors wishing to invest in BTCST provided an investment of money.”

– US v. Ulbricht, Case No. 14-cr-68, Opinion & Order (SDNY 7/9/14): Bitcoins constitute “funds” for purposes of the federal criminal money laundering laws.

– US v. Faiella and Shrem, Case No. 14-cr-243, Memorandum Order (SDNY 8/19/14): “Bitcoin clearly qualifies as ‘money’ or ‘funds’” for purpose of the federal criminal money laundering and illegal money transmission laws.”

Legal Status of Bitcoin • Bank Secrecy Act / Anti-money Laundering (BSA/AML)

– Per the Financial Crimes Enforcement Network (“FinCEN”) guidance on virtual currency

"virtual" currency is a medium of exchange that operates like a currency in some environments, but does not have all the attributes of real currency. In particular, virtual currency does not have legal tender status in any jurisdiction. This guidance addresses "convertible" virtual currency. This type of virtual currency either has an equivalent value in real currency, or acts as a substitute for real currency. http://fincen.gov/statutes_regs/guidance/html/FIN-2013-G001.html

• Taxation

– Per Internal Revenue Service (“IRS”) guidance bitcoin is not a currency, but rather property and taxable as such

• Commodity

– While the Commodities Futures Trading Commission (“CFTC”) has not issued specific guidance on bitcoin, it has stated that it is actively studying whether it has jurisdiction.

Increased Scrutiny by Governmental Agencies • Congressional Review

– Senate Homeland Security Committee - November 2013 Hearings

– House Small Business Committee - April 2014 Hearings

• Federal Agencies

– Financial Crimes Enforcement Network of the Department of Treasury (“FinCEN”)

– Other financial crimes enforcement groups involving Treasury/Department of Justice/Banking Agencies

– Internal Revenue Service

– Consumer Financial Protection Board (“CFPB”) – August 2014 Report

Examples of US Laws that May Apply

• Federal and state taxation

• Bank Secrecy Act / anti-money laundering / anti-terrorist laws

• Economic sanctions laws overseen by Office of Foreign Asset Control (“OFAC”)

• Securities/Commodities

• State Money Transmittal/Bill Payment Licenses

– Some apply to “monetary value” or “stored value”

Increased Scrutiny by State Governmental Agencies

• State Agencies

– Conference of State Bank Supervisors

– North American Securities Administrators Association

– Individual States (Compare NY versus TX)

State Licensure – New York

• Jan 28-29, 2014 - Public hearings held to consider whether to regulate virtual currency (including Bitcoin)

The question is what type of licensing, examination, and collateral requirements for the virtual currency industry will provide appropriate guardrails to protect consumers and our national security without stifling beneficial innovation.

• BitLicense Proposal – Until Oct. 21, 2014 to comment

Mixed but mostly negative industry reaction. http://www.dfs.ny.gov/legal/vcrf_submit_comments.htm

State Licensure – Texas

• Supervisory Memorandum 1037 (Apr. 3, 2014)

• Exchanging virtual currency for sovereign currency is not currency exchange under the Texas Financial Code.

• Centralized virtual currencies must be analyzed on a case by case basis, but “cryptocurrencies” (e.g., bitcoin) are not money or monetary value under the Money Services Act.

– Exchange of cryptocurrency for sovereign currency between two parties is not money transmission.

– Transfer of cryptocurrency by itself is not money transmission

– Exchange of cryptocurrency for sovereign currency through a third party exchange generally IS money transmission.”

Threat landscape

Unregulated markets attract illicit actors • Evolving regulatory treatment, security and

technology present opportunities for threat actors • Money laundering and cybercrime appear to be

the most imminent threats • Concern about transnational illicit networks

(human trafficking, narcotics, threat finance, terrorist financiing)

• One countervailing view on risk – for the criminal, cash will still beat digital currency

Different threat actors, different aims • Micro Threats: hackers, rogue elements, local

criminal enterprise • Macro Threats: nation states, foreign intelligence

services and military, transnational organized crime • Who are they and why are they interested? • What are their intentions and possible impact on

your organization? • Benefit weighed against risk of disruption

Cyber theft

• Cyber attack on Bitcoin wallets already common • Mt. Gox. Say no more. • Theft of BTC from exchangers Bitcoinica and

BIPS

Money Laundering case: Silk Road

• Online marketplace for illegal goods and services

• Only form of payment accepted on Silk Road was Bitcoins

• FBI shut down Silk Road and arrested its founder in San Francisco in October 2013

• Silk Road website was configured with its own payment system that required users to establish a “Silk Road Bitcoin address,” in addition to their own personal Bitcoin address, that would be stored on a Bitcoin “wallet” maintained on servers controlled by Silk Road

» Silk Road system utilized so-called “tumbler” technology to process Bitcoin transactions in a way that obscured any link to the personal Bitcoin addresses of users

» Silk Road effectively frustrated the Bitcoin Blockchain system to enable anonymous criminal transactions that could not even be traced to the parties’ anonymous Bitcoin addresses

• FBI seized 173,991 BTC from the Silk Road founder, worth approximately $33.6 million

Money Laundering case: Silk Road Use of “tumbler” to anonymize users

Silk Road utilized “tumbler” technology to send individual transactions through a complex series of dummy transactions that disguised the link between buyers and sellers, and thus processed Bitcoin transactions in a way that obscured any link to the personal Bitcoin addresses of users

Malcolm Rowe Director

PwC

Financial Services Regulatory Practice

917-443-2059

Malcolm.rowe@us.pwc.com