Bitcoin: the Napster of currency.

• Author: Small, Stephen
• Position: I. Origin and Explanation of Bitcoin through II. Uses of Bitcoin, p. 581-611

1. Origin and Explanation of Bitcoin A. Brief History of the Founding of Virtual Currencies B. What is Bitcoin? II. Uses of Bitcoin A. Illegal Uses of Bitcoin B. Legal Uses of Bitcoin III. International Response A. China B. Germany C. Canada IV. U.S. Regulation A. Current Regulation B. Proposed Reform of Regulation V. Taxation A. Taxation Strategies Examined B. Proposed Tax Reform VI. Conclusion In a 1917 letter, Albert Einstein offered his views of technological progress being like an axe in the hands of a pathological criminal. (1) Almost a century later, it is hard to doubt Einstein's foresight. The best demonstration of technological progress in our lifetime undoubtedly is the internet. The wealth of knowledge and ease of communication the information superhighway has brought to the world is without parallel; however, just as Einstein predicted, with any technological advancement there is always the possibility of a sinister use.

   In the case of the internet, one such malicious use is aptly referred to as "the darknet," a largely unknown portion of the internet which is only reachable through the use of special encryption software which allows users to remain completely anonymous while browsing certain sites. (2) The darknet has earned the reputation as the Wild West of the internet, because there truly is no semblance of authority. (3) One of the most popular sites darknet users browsed was the now defunct site, Silk Road. (4) Launched in February 2011, this infamous website became the virtual representation of the stereotype people imagine when they hear the phrase, "black market." The "wares" available for purchase on this site were what anyone would typically expect; mainly: narcotics, hacked documents, and illegal firearms. (5) Unfortunately, there are a plethora of other sites on the darknet that offer a wide variety of vices including: illegal porn, (6) online gambling, (7) hacking services, (8) and even murder for hire. (9) In keeping with the anonymous nature of the darknet, the exclusive currency used for these transactions is Bitcoin, a digital cryptocurrency. (10)

   It is this substantial link to criminal activities that has fueled the talk of regulating Bitcoin. A number of countries have already enacted regulatory frameworks to combat these concerns, (11) but the United States has only issued limited guidance concerning the matter. (12) In August 2013, the Senate Homeland Security and Governmental Affairs Committee launched an investigation into what policies various government agencies (13) are enacting to regulate virtual currencies. (14) The hearing resulted in many agencies giving Bitcoin a positive recommendation, but there was still a substantial group that expressed skepticism on the use of the digital currency. (15)

   Certainly, there is no denying Bitcoin's auspicious beginnings, which Part I will cover in detail, as well as offer a brief introduction to Bitcoin and further discussion on the important characteristics of this revolutionary currency. Part II will lay out the reasoning behind the regulatory debate by discussing both legal and illegal uses of Bitcoin. Part III will examine the actions of other foreign governments, focusing exclusively on the regulatory and taxation policies undertaken by the governments of China, Germany, and Canada. The focus of Part IV will consist of a proposed strategy on how the United States can best regulate Bitcoin. After proposing the strategy, there will be a discussion highlighting the advantages this plan offers to law enforcement, businesses, and consumers. Part V will examine the various potential taxation strategies scholars argue Bitcoin falls under and compare them to the strategies deployed by Germany and Canada. This section then goes on to propose an ideal taxation strategy for the United States, which would be favorable to both consumers and investors, without jeopardizing the sufficient collection of personal tax liability.

1. Origin and Explanation of Bitcoin

   1. Brief History of the Founding of Virtual Currencies

      Many of the virtual currencies can trace their origins to the growing tide of distrust of government and financial sectors. The first virtual currency to really sustain any popularity was WebMoney, which was launched in response to the collapse of the Russian banking sector in 1998. (16) A number of external and internal influences caused this financial disaster, but certainly the driving force was the decline in the Russian stock market. (17) Over the course of the first eight months of 1998, the Russian stock market lost approximately 75% of its value. (18) On August 17, 1998, the Russian government responded to the economic crisis by devaluing their currency, defaulting on domestic debt, and declaring a moratorium on payments to foreign creditors. (19) With faith lost in the Russian economy and their currency heavily devalued, many of the largest commercial banks closed. (20) As a result, millions of Russians saw their savings disappear virtually overnight. (21)

      WebMoney seized this opportunity by directing its initial marketing strategy at those individuals who lost complete trust in the banking sector but still remained interested in conducting e-commerce. (22) By becoming one of the first entities in Russia to develop a system that allowed a user to fund an account for online purchases without the requirements of a bank account or credit card, (23) WebMoney quickly established itself as an indispensable instrument of commerce within a chaotic Russian economy. (24) The primary element of the currency's success was the development of two user-friendly ways to fund an account. The first was essentially a reverse ATM, called a "cash-kiosk." (25) WebMoney installed these machines all around high-traffic areas, such as shopping malls, theatres, and subways. (26) All users had to do in order to deposit funds into their accounts was simply type in their WebMoney identification number and deposit cash. The second, arguably more user-friendly way, is akin to a gift card. (27) A consumer simply went to a store and bought a card worth a specified amount. (28) In order to fund the account, users would log into their account and type in the pin number located on the back of the card. (29) Because of its popularity, WebMoney has become a staple in Russian daily life with many vendors, including cell phone companies, internet providers, and cable providers accepting it as a form of payment. (30)

      Since its launch, WebMoney has attempted to expand worldwide and now has over 28 million users conducting roughly 450,000 transactions daily. (31) However, it appears that this virtual currency has not been able to gain a strong foothold outside of Russia, since almost two-thirds of the transactions take place on Russian servers. (32) Although there have been many virtual currencies over the past decade and a half, (33) it was not until 2011 that a virtual currency has finally been able to achieve global notoriety. (34)

   2. What is Bitcoin?

      Bitcoin is a peer-to-peer payment system that launched on January 3, 2009. (35) There is little known about the creator(s) because all of the original discussions about the currency and protocols were published under an alias, Satoshi Nakamoto. (36) For the first few years of its existence, Bitcoin stood as a novel idea of how financial transactions in the future would be conducted. (37) However, by March 2013, the currency had proven itself to be a legitimate and viable form of currency when it reached an astonishing total value of over one billion dollars. (38)

      The popularity of Bitcoin can at least be partially attributed to the ease with which it can be acquired. In order to obtain bitcoins, a user must first...