An Explanation of Bitcoin and its Implications for Consumer Protection

D'Juan Jones, NAGTRI Law Clerk

Bitcoin has been described as a decentralized, peer-to-peer version of electronic cash that facilitates the purchase of online goods and services without an intermediate financial institution.[1] This definition highlights the key differences between Bitcoin and traditional currencies, such as the U.S. dollar, and commonly used forms of online payment, such as credit and debit cards. Bitcoin can be directly exchanged from one party to another, and the transaction does not require an intermediate bank or clearinghouse to validate the transfer.[2] Moreover, Bitcoin is not tied to any government; Bitcoin is not created, controlled, or regulated by a central body.[3] Bitcoin appeals to consumers because the peer-to-peer characteristic of the currency eliminates third-party fees and reduces transaction costs.[4] Additionally, consumers are drawn to invest in Bitcoin because of the possibility that it will increase in value as time progresses, resulting in a higher return on investment.[5]

Using Bitcoin

Bitcoin has primarily been used as a medium of exchange for online purchases. In order to begin using Bitcoin, a consumer must first create a virtual wallet.[6] After a virtual wallet has been created, the consumer can begin the process of bitcoin acquisition.[7] Once bitcoins are in the virtual wallet—the equivalent of money in an account—the consumer can purchase goods or services online or at any physical location that accepts Bitcoin as a payment method.[8]

Creating A Virtual Wallet

It is helpful to think of a virtual wallet as a combination of a traditional wallet and an email address. Similar to a traditional wallet, the virtual wallet stores the bitcoins of the consumer and allows the consumer to keep track of their Bitcoin balance.[9] Much like an email address, virtual wallets within Bitcoin interoperate, which allows users to send and receive bitcoins to one another.[10] Each wallet comes with one private key, which is available only to the owner of the virtual wallet, and an infinite number of public keys, which are used to send and record the transfer of bitcoins.[11] The public key encrypts bitcoins to ensure safe arrival to the recipient, and the private key decrypts bitcoins once they have reached the intended virtual wallet. [12] The following example describes the process:

Buyer (B) purchases a product from Seller (S) for a price of two bitcoins. S gives B his public key, which enables B to send two encrypted bitcoins to pay for the product. S then accepts the two bitcoins by inputting his private key, which decrypts the transaction and places the bitcoins into his virtual wallet. All Bitcoin users can view the exchange of the two bitcoins, but only S is able to accept the bitcoins because of his unique private key.[13]

Acquiring Bitcoin

After the creation of a virtual wallet, a consumer can begin the acquisition of bitcoins using any of the following methods:

  • mining,
  • purchase using traditional currency through exchange sites, and
  • selling products and services.

Mining

Mining is an integral part of Bitcoin and serves multiple purposes. The process of mining creates additional bitcoins, validates transactions, and maintains the record of transactions within Bitcoin.[14] The process of mining is best explained with the following scenario:

Buyer (B) purchases a product from Seller (S) for a price of two bitcoins. In order to complete this transaction, a miner must ensure that B is in possession of two bitcoins. A miner utilizes programming software to solve a complex Bitcoin algorithm to ensure B has the two bitcoins. If B has the bitcoins, the miner then records the transaction between B and S in a general ledger, known as a block chain. The block chain is the record of all transactions that have occurred on the Bitcoin network.[15] After the miner has validated the transaction and the transaction has been completed, the miner is rewarded for his work by receiving newly-produced bitcoins.[16]

The act of mining is competitive because miners within Bitcoin are essentially “racing” to solve the algorithm and receive the bitcoins.[17] The more processing power of an individual, the higher probability they will solve the algorithm and record the transaction.[18] In response to the miners acquiring more processing power and solving the algorithms faster, the Bitcoin algorithm becomes more difficult in an effort to stabilize the amount of bitcoins created and awarded.[19] The amount of bitcoins awarded to miners decreases over time, similar to gold that is being mined. Just as the supply of gold is limited, the number of Bitcoins is limited to 21 million; the last bitcoins will be mined in 2140.[20]

Purchasing Bitcoin

A consumer can purchase bitcoins through an online exchange.[21] These online exchanges—such as Mt. Gox—operate in the same fashion as exchanges for traditional currencies. The going rate of bitcoins, which fluctuates dramatically, is exchanged for a traditional currency.[22] The exchange site receives a commission for the service of converting the traditional currency into bitcoins, and the consumer receives bitcoins for their virtual wallet.[23]

Selling of Goods and Services

An individual can also acquire bitcoins by accepting the currency in exchange for goods and services.[24] In exchange for a good or service, either online or in person, the seller is compensated with bitcoins that are transferred into their virtual wallet.[25] In addition to online transactions, an increasing number of real-world locations have agreed to accept bitcoins—ranging from a dentist in Kansas to a sushi restaurant in Massachusetts.[26]

Consumer Risks

Bitcoin poses several risks to consumers. The most notable risks include:

  • hacking of virtual wallets or Bitcoin platforms,
  • the fluctuating value of Bitcoin,
  • fraudulent transactions, and
  • lack of legal protection and recourse for consumers.

Hacking

As with many systems that operate online, the Bitcoin network is susceptible to hacking. Hackers can steal the bitcoins of consumers by gaining access to Bitcoin platforms or by compromising the virtual wallets of the consumer.[27] This threat has actualized multiple times since the inception of Bitcoin; one of the most notable examples is Mt. Gox.[28] Mt. Gox, a Tokyo-based exchange, was once the dominant platform for Bitcoin exchange.[29] The platform filed for bankruptcy protection in February 2014 after hackers allegedly gained access to the platform and heisted nearly $480 million worth of bitcoins.[30] The stolen bitcoins belonged to both consumers, who relied on the exchange site for storage and conversion of their currency, and the company.[31]

In addition to the hacking of virtual wallets and exchange platforms, malware has been distributed to consumers’ computers.[32] Miners—turned hackers—distribute the malware and leech the processing power of consumer computers to help in the mining process.[33] There have also been instances of consumers accidently deleting their virtual wallets that are stored on their computers.[34]

Fluctuating Value

Bitcoin is not backed by a government and is not based on any real-world commodity, such as gold or a central bank, and consequently the value of Bitcoin fluctuates dramatically.[35] Bitcoin is not a legal tender—no law requires companies or individuals to accept it—Bitcoin will become worthless if no entity will accept it as a form of payment.[36] Also, Bitcoin has become the currency of choice for illegal transactions.[37] In an effort to combat illegal transactions, law enforcement could shut down or restrict the use of platforms and exchanges at any time.[38] Such action would limit the consumer’s ability to spend bitcoins, lessen the value of bitcoins, or cause the consumer to lose bitcoins.[39] This type of action was recently taken in China. China’s Central Bank ordered third-party payment processors to cease transactions involving digital currencies, shortly after banning financial institutions from accepting Bitcoin.[40] China’s Central Bank argued that the illegal use of the currency could harm average Chinese consumers.[41] The action of the Chinese officials had an immediate and catastrophic effect on the value of Bitcoin, which is discussed below.

Consumers are often drawn to invest in Bitcoin because of the perception that it will mirror other innovative investment opportunities by increasing in value over time.[42] Nearly two years ago, following positive Bitcoin media coverage, the value of bitcoins jumped from $1 to $28.[43] However, the dramatically fluctuating value of Bitcoin makes it especially dangerous to potential investors.[44] For example, after China announced that Bitcoin transactions would not be tolerated by its financial institutions and banned Bitcoin transactions by third-party payment processors, the value of Bitcoin dropped nearly 40 percent in less than 24 hours.[45] In sum, the profits or losses associated with Bitcoin investment are virtually impossible to predict because of its volatile worth.

Fraud

The newness of Bitcoin makes it attractive to fraudsters because of the evolving nature of the system.[46] This characteristic attracts fraudsters because they are able to easily present themselves as legitimate Bitcoin entities in the midst of change and growth.[47] Fraudsters are able to pose as a “new” Bitcoin exchange, a Bitcoin intermediary or a Bitcoin trader in an effort to lure consumers to send money.[48] The anonymity of Bitcoin and the irreversibility of transactions results in a permanent loss for consumers and little, if any, consequence for fraudsters.[49]

Fraudsters have perpetuated fraudulent investment schemes that promise consumers access to cutting-edge opportunities with guaranteed high returns on investments.[50] The U.S. Securities and Exchange Commission (SEC) has taken measures to combat such fraudulent investment opportunities. In SEC v. Shavers, the SEC charged Trendon T. Shavers for an alleged Ponzi scheme that involved Bitcoin.[51] The “investment opportunity” promised investors 7 percent interest per week on their investment, and that investment proceeds would be used to further the activities of Bitcoin.[52] However, Shavers used the funds of new investors to pay the expected interest of prior investors and misappropriated funds for his personal use.[53] These types of schemes are common with new systems because consumers have difficulty differentiating legitimate opportunities from scams amongst the growth of the system.[54]

Legal Recourse and Law Enforcement

Consumers are left with little or no legal recourse when the aforementioned risks materialize. Federal Deposit Insurance Corporation (FDIC) insurance, which covers deposits in U.S. banks, does not extend to a consumer’s bitcoins or virtual wallet because Bitcoin is not backed by the U.S. government.[55]

Law enforcement faces substantial obstacles in identifying and punishing individuals responsible for theft or fraud of Bitcoin. Firstly, the anonymity of Bitcoin makes it difficult to trace the currency.[56] Bitcoin transactions are peer-to-peer and eliminate the need for banks, which makes it more difficult to follow the flow of bitcoins than it is the U.S. dollar.[57] Additionally, the anonymity and lack of central authority means that there is no collection of consumer identity information.[58] Investigators must rely on Bitcoin exchange sites and other potentially unreliable sources in their attempts to identify consumers who have suffered losses.[59] Secondly, the international scope of Bitcoin transactions makes it exceedingly difficult for investigators to obtain information.[60] For example, although the SEC regularly obtains information from abroad through cross-border agreements, there may be domestic restrictions on the use of this information, or difficulty obtaining the pertinent information.[61] Thirdly, when law enforcement is able to locate stolen bitcoins, it is difficult to seize or freeze the currency because of the encryption of virtual wallets.[62]

Consumers also have limited options in recovering lost or stolen bitcoins. For example, consumers were unable to recover their bitcoins after the breach of Mt. Gox.[63] The only legal redress available for consumers were those remedies that exist to anyone who entrusts their property to an institution that fails to keep it protected—such as negligence, breach of contract or fraud.[64] Moreover, even if a consumer is successful on one of these claims, Mt. Gox’s liabilities greatly outweighed its assets.[65] Mt. Gox would not be able to pay any judgments that the court would enforce to remedy the injuries of consumers.[66]

Consumer Self-Protection

Consumers can take preventive measures to protect themselves from potential loses. Such measures are of little cost to the consumer and include:

  • researching brokers before investing,
  • greater protection of virtual wallets, and
  • acquiring minimal amounts of Bitcoin.

Broker Investigation

A consumer should perform thorough research before making monetary commitments to an investment opportunity.[67] The consumer should carefully read the material presented by a broker and verify all statements and promises.[68] A consumer can investigate the backgrounds of the firms or individuals offering the investment by searching the SEC’s Investment Adviser Public Disclosure, the Financial Industry Regulatory Authority’s (FINRA) BrokerCheck website, http://brokercheck.finra.org/Search/Search.aspx, and by contacting the state’s securities regulator.[69] A consumer should perform diligent research on potential Bitcoin investment just as they would on any other investment opportunities.

Protection of Virtual Wallets

The average consumer does not typically carry thousands of dollars in their wallet, purse or pocket and the same should hold true for virtual wallets.[70] If a virtual wallet is hacked, the consumer will mitigate losses by only having a small amount of Bitcoin in an online virtual wallet, and storing the bulk of their Bitcoin in more secure locations, which are discussed below.[71]

Storing a virtual wallet offline, known as “cold storage,” provides the highest level of security for Bitcoin.[72] An offline wallet is protected from malware or other internet tools that are used by hackers to compromise virtual wallets and steal bitcoins. Moreover, an offline wallet that is encrypted, backed up regularly, and stored on alterative media (such as a USB drive) will greatly reduce the likelihood of Bitcoin theft.

Acquiring Minimal Amounts of Bitcoin

The most important tip for consumers is to only invest money that they can afford to lose.[73] Consumers should not invest or turn savings or substantial monetary amounts into bitcoins. Essentially, consumers should invest an amount in Bitcoin that they are fiscally comfortable with losing. Consumers should make sound investments while conscious of the reality that if fraud or theft occurs, they will likely be unable to recover any losses.[74]

Conclusion

The potential for Bitcoin is vast, and unfortunately so too are the risks to consumers. Law enforcement faces several obstacles in providing recourse for injured Bitcoin users and the international scope of Bitcoin magnifies the issues. There is minimal regulation in the area of digital currencies, and until sufficient regulation exists, informed and cautious consumers are the best defense against the shortcomings of Bitcoin.



[1] Investor Alert: Bitcoin and Other Virtual Currency-Related Investments, U.S. Secs. & Exch. Comm’n, http://investor.gov/news-alerts/investor-alerts/investor-alert-bitcoin-other-virtual-currency-related-investments#.U4cy_fldXuN (last visited May 26, 2014).

[2] What is Bitcoin?, Cnn Money, http://money.cnn.com/infographic/technology/what-is-bitcoin/ (last visited May 26,2014).

[3] U.S. Secs. & Exch. Comm’n, supra note 1.

[4] Cnn Money, supra, note 2

[5] Andrea Peterson, Bitcoin Value Drops 40 Percent After More Bad News from China, the Washington post, (Dec. 18, 2013, 8:30 AM), http://www.washingtonpost.com/blogs/the-switch/wp/2013/12/18/bitcoin-value-drops-40-percent-after-more-bad-news-from-china/.

[6] How To Get Bitcoins, Blockchain, https://blockchain.info/wallet/how-to-get-bitcoins (last visited May 27, 2014).

[7] Id.

[8] Cnn Money, supra, note 2.

[9] Choose your Bitcoin wallet, Bitcoin, https://bitcoin.org/en/choose-your-wallet (last visited May 27, 2014).

[10] Id.

[11] Jeffrey D. Neuburger & Jonathan P. Mollod, The Exciting Present and Uncertain Future of Bitcoins and Digital Currency, Westlaw J. Computer & Internet, April 14, 2014, at 2, available at 2014 WL 1630385.

[12] Id.

[13] Id.

[14] Bitcoin: More than a Bit Risky, Finra Investors, http://www.finra.org/investors/protectyourself/investoralerts/fraudsandscams/p456458 (last visited May 27, 2014).

[15] Id.

[16] Kelsey L. Penrose, Banking on Bitcoin: Applying Anti-Money Laundering and Money Transmitter Laws, 18 N.C. banking inst. 529, 533 (2014).

[17] Neuburger & Mollod, supra note 11, at 3.

[18] Id.

[19] Penrose, supra note 14, at 532.

[20] Chris Morris, Bitcoin: CNBC Explains, CNBC, (April 15 2013, 3:03 PM), http://www.cnbc.com/id/100642495.

[21] Neuburger & Mollod, supra note 11, at 3.

[22] Id.

[23] Id.

[24] Id.

[25] Id.

[26] Morris, supra note 20.

[27] Finra Investors, supra note 14.

[28] Id.

[29] Id.

[30] Ben McLannahan, Bitcoin Exchange Mt. Gox Files for Bankruptcy Protection, financial times (Feb. 28, 2014, 6:35 pm), http://www.ft.com/intl/cms/s/0/6636e0e8-a06e-11e3-a72c-00144feab7de.html?siteedition=intl#axzz2v8w0y2mI.

[31] Id.

[32] Hannah Kim, Betting on the Bitcoin Buzz, NASDAQ, (Sept. 20, 2013, 2:38 PM), http://www.nasdaq.com/article/betting-on-the-bitcoin-buzz-cm279095.

[33] Id.

[34] Id.

[35] Id.

[36] Finra Investors, supra note 14.

[37] See Donna Leinwand Leger, How FBI Brought Down Cyber-Underworld Site Silk Road, USA TODAY (May 20, 2014, 6:12 AM), http://www.wcnc.com/news/crime/How-FBI-brought-down-cyber-underworld-site-Silk-Road-259794841.html (Indicating the significance of Bitcoin in illicit transactions).

[38] Finra Investors, supra note 14.

[39] Id.

[40] Peterson, supra note 5.

[41] Id.

[42] U.S. Secs. & Exch. Comm’n, supra note 1.

[43] Morris, supra note 20.

[44] U.S. Secs. & Exch. Comm’n, supra note 1.

[45] Peterson, supra note 5.

[46] U.S. Secs. & Exch. Comm’n, supra note 1.

[47] Id.

[48] Finra Investors, supra note 14.

[49] Id.

[50] U.S. Secs. & Exch. Comm’n, supra note 1.

[51] Id.

[52] Id.

[53] Id.

[54] Id.

[55] Id.

[56] Id.

[57] Id.

[58] Id.

[59] Id.

[60] Id.

[61] Id.

[62] Id.

[63] Joseph Ax and Karen Freifield, Mt. Gox Bitcoin Customers Could be Out of Luck, Experts Warn, Reuters (Feb. 27, 2014, 5:46 AM), http://www.reuters.com/article/2014/02/27/us-bitcoin-legal-idUSBREA1Q07U20140227.

[64] Id.

[65] Id.

[66] Id.

[67] U.S. Secs. & Exch. Comm’n, supra note 1.

[68] Id.

[69] Id.

[70] Securing Your Wallet, BITCOIN, https://bitcoin.org/en/secure-your-wallet (last visited May 30, 2014).

[71] Id.

[72] Id.

[73] Finra Investors, supra note 14.

[74] Cadie Thompson, More Bitcoins, More Problems: How Hackers Are Targeting Bitcoins, CNBC (Nov. 20, 2013, 9:34 AM), http://www.cnbc.com/id/101213462.

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