88164 BRIEF Bitcoin Versus Electronic Money Bitcoin has had a volatile journey since it was launched in 2009, attracting attention among conventional investors as well as the black market. Regulators and policy makers are also following Bitcoin, raising the occasional eyebrow as they evaluate Bitcoin’s risks and benefits and how to regulate this little understood virtual currency. Some media reports have confused Bitcoin with more popular electronic money (e-money) schemes used in many low-income countries to reach the unbanked. But the two are markedly different and should not be conflated. This Brief provides information about Bitcoin and contrasts Bitcoin with e-money to avoid alarm about the former to the detriment of the latter. Virtual Currency is the first example of a growing category of money known as cryptocurrency in which open-source software One way to comprehend virtual currency is to first solves complex mathematical calculations to mine more understand fiat currency. Fiat currency is any legal Bitcoins (Coin Desk 2013a). These “miners” make the tender designated and issued by a central authority Bitcoin network function by validating transactions and that people are willing to accept in exchange for thereby creating new Bitcoins. This occurs when the goods and services because it is backed by regulation Bitcoin network collects all the transactions made during and because they trust this central authority. Fiat a set period of time (usually every 10 minutes) into a money is similar to commodity-backed money in list called a “block.” Miners confirm these blocks of appearance and usage, but differs in that it cannot be transactions and write them into the block chain by redeemed for a commodity, such as gold (European competing against each other to solve mathematical Central Bank 2012).1 calculations. Every time a miner’s system finds a solution that validates a block of transactions, that miner is By contrast, virtual currency is “a type of unregulated, awarded 25 Bitcoins (Coin Desk 2013b). Every four digital money, which is issued and usually controlled years, this reward is halved so that the total number of by its developers, and used and accepted among Bitcoins will never exceed 21 million.2 the members of a specific virtual community.” Although there are different types of virtual currencies For a new user not interested in the mining process, (European Central Bank 2012), this Brief will focus the most popular way to obtain Bitcoins is through a on virtual currencies with “bidirectional flow” since traditional exchange where fiat currency is converted these currencies intersect most directly with the real into Bitcoins and then stored in a Bitcoin wallet. economy. Virtual currencies with bidirectional flow may Wallets come in many forms, including desktop access, be bought and sold according to prevailing exchange mobile access, and online web-based access. Each rates and may be used to purchase both real and has its own risks as both desktop and mobile access virtual goods and services. are susceptible to hackers, a hard drive crash, or a lost mobile device. Online access uses third parties that Bitcoin may also be hacked, cheat its users, or go bankrupt (Lee 2013). Bitcoin was launched in 2009 as an alternative to fiat currencies by an unknown computer scientist using the Bitcoin wallets hold the digital private encryption pseudonym Satoshi Nakamoto (n.d.). Bitcoins are not keys, or secret codes, needed to carry out Bitcoin printed like fiat money, but instead are “mined” using transactions. Let’s say Person A wants to send five computing power in a distributed global network of Bitcoins to Person B. Person A uses a private key to volunteer software developers. At its core, Bitcoin is sign a message with the input (the Bitcoin address nothing more than a digital file that lists every transaction used to send Bitcoins to Person A in the first place), that has ever happened in the network in its version the amount (five Bitcoins), and the output (Person of a general ledger called the “block chain.” Bitcoin B’s Bitcoin address). Person A sends this message 1 European Central Bank (2012) provides an excellent overview of virtual currencies, including two case studies on Bitcoin and Second Life’s Linden Dollars. 2 There are 210,000 10-minute increments over four years; therefore, the award is halved after 210,000 blocks have been written into the block chain. During the first four years of the Bitcoin network when the reward was 50 Bitcoins, 10.5 million Bitcoins were created (210,000 multiplied by 50 Bitcoins). January 2014 2 from Person’s A Bitcoin wallet into the wider Bitcoin addresses, but it is still difficult to link a public network from where miners verify the transaction once address to a person’s identity. it becomes part of a block by solving a mathematical 4. It is transparent. Although Bitcoin transactions are calculation (CoinDesk 2013c). The mathematical somewhat anonymous, they are also transparent. component of the system is important to prevent Bitcoins are really only records of Bitcoin fraud by ensuring that a person cannot use the same transactions between different addresses making Bitcoin for multiple transactions. up the block chain. Everyone on the network can see how many Bitcoins are stored at each public Bitcoin differs from fiat currency in the following key Bitcoin address, but they cannot easily identify to ways: whom the address belongs. 5. It is irrevocable. There is no way to chargeback 1. It is decentralized. Bitcoin is based on a decentralized, a Bitcoin transaction unless the recipient actually peer-to-peer network that does not have a central sends the coins back to the sender. clearing house or any other intermediary. No single institution controls the Bitcoin network like a central Bitcoin versus E-Money bank does with fiat currency. Every machine that mines Bitcoins and processes transactions makes up E-money is commonly defined as value (i) stored a part of the network. electronically, (ii) issued on receipt of funds of an 2. It is not inflationary. Unlike fiat currency, which can be amount not less in value than the monetary value printed to create more supply, Bitcoin was designed issued, and (iii) accepted as a means of payment by to have a maximum number of coins. Only 21 million parties other than the issuer.3 In e-money schemes, the will ever be created according to a predetermined link between e-money and fiat currency against which algorithm. There are about 12 million Bitcoins it is issued remains intact, as funds are expressed in currently in existence (Lee 2013). This represents 57 units of that currency (U.S. dollar [USD], Euro [EUR], percent of all the Bitcoins that will ever be created, Kenyan shilling [KES], etc.). In virtual currency schemes, and by 2017, 75 percent will have been created. The by contrast, the unit of account has no physical fiat last Bitcoin will be mined in 2140 (Hern 2013). currency counterpart (European Central Bank 2012). 3. It is anonymous, sort of. Users can hold multiple See Table 1 for more information. public Bitcoin addresses, but they are not linked to names, physical addresses, or other identifying Aside from being digital in format, there are few information. However, as discussed below, recent similarities between Bitcoin and e-money. E-money, regulation of exchanges has made it more difficult to like many other digital forms of fiat currency, such retain the anonymous aspect of Bitcoin. Researchers as credit and debit cards, PayPal, and wire transfers, have also found ways to track transactions of public is simply one mechanism by which to interact with Table 1. Comparison between e-money and Bitcoin E-Money Bitcoin Format Digital Digital Unit of account Fiat currencies (USD, EUR, KES) Bitcoins (BTC) Customer identification Financial Action Task Force Anonymous (FATF) standards apply for customer identification (though such standards permit simplified measures for lower risk financial products) Means of production Digitally issued against fiat Mined/mathematically generated currency of central authority Issuer Legally established e-money Community of people/miners issuer (which may be a financial institution) Source: Adapted from European Central Bank (2012). 3 The European Commission Electronic Money Directive (2009/110/EC). http://ec.europa.eu/internal_market/payments/emoney/text/index_en.htm 3 that fiat currency. To mitigate against systemic and controls, this was an important step in addressing the consumer protection risks, the cash against which risks presented by the anonymity of virtual currencies. e-money is issued typically must be deposited with fully prudentially regulated financial institutions (Tarazi Silk Road aside, the biggest current risk of Bitcoin and Breloff 2010). In contrast to Bitcoin, e-money is not is uncertainty surrounding its future, which depends a separate currency and is overseen by the same central largely on the number of active users and accepting authority as the underlying national currency. Confusion merchants. Since Bitcoins cannot currently be used between the two may have arisen recently from a news to purchase many things directly,6 most users and story that inaccurately associated Bitcoin with M-PESA, merchants will convert them back into a fiat currency the mobile payments service used by over 11 million of choice. Conversion from fiat currency to Bitcoin and customers in Kenya popular for its potential to provide back again most regularly happens using an exchange. financial services to the financially excluded.4 If exchanges begin to be more systematically regulated, as they are in the United States, then their Risks use can be more closely monitored and controlled (Hoskinson 2013). Bitcoin users, however, can The abstract nature of Bitcoin poses a challenge to transact, buy, and sell outside of these exchanges, regulators. Like any form of monetary value, including so not everyone will be monitored. The global nature cash, e-money, and credit cards, Bitcoin can be used of the Bitcoin network also needs to be considered. for both legitimate and illicit purposes. The question is Many developing countries lack the regulatory whether Bitcoin makes it easier for criminals to funnel framework or the capacity to track this new type of money for illicit purposes, and how regulators should financial innovation. The largest Bitcoin exchange, for respond to these perceived or real risks. example, is now located in China.7 However, China’s central bank recently barred financial institutions from Much of this discussion came to a head with the recent handling Bitcoin transactions (Bloomberg News 2013). crackdown of Silk Road, an underground market launched in January 2011 that accepted Bitcoins The fluctuation of Bitcoin’s value also adds to its risk. exclusively for the purchase of illicit goods and services. Bitcoin is not pegged to any real-world currency. Its With the double layer of anonymity created by Bitcoin value is determined by supply and demand and trust in and the Tor browsing system used by Silk Road, the system. Following the closure of the underground money on the Silk Road site was almost untraceable. market Silk Road in October 2013, the value of Bitcoin Nevertheless, the U.S. Federal Bureau of Investigation dropped from $139 to $109 in less than three hours was able to finally track down the founder of Silk Road and bottomed out at $99 (Mattise 2013). This has led in October 2013 (Time 2013). By the time it was shut to Bitcoin being used more as a speculative investment down, Silk Road had processed sales totaling more tool than a currency or payment system. While there than 9.5 million Bitcoins, worth about $1.2 billion.5 are now estimated to be 93,000 transactions per day, Regulators in the United States have begun to take the majority of Bitcoins (around 55 percent) are not notice of the increasing use of Bitcoin. The Financial in circulation (Schrade 2013). Bitcoins are also not Crimes Enforcement Network (FinCEN), the Financial immune to fraud. As of November 2013, approximately Intelligence Unit within the U.S. Treasury Department 800,000 Bitcoins have been stolen (Schrade 2013). that focuses on all anti-money laundering (AML) Since all Bitcoin transactions are irrevocable, there is no and combatting the financing of terrorism (CFT) recourse for users who suspect they are or have been regulation, issued guidance in March 2013 defining the victim of fraud. One can argue that consumers now the circumstances under which virtual currency users have a choice: either pay higher fees for services that could be categorized as a money transmitting business offer chargeback services in the case of fraud or pay (MTBs) (FinCEN 2013). Since MTBs must enforce AML lower fees for services with little to no recourse. 4 The article claimed that Kipochi (a Kenya-based Bitcoin wallet accessible via mobile phones) launched a product that allowed people in Africa to send and receive Bitcoins. Several statements in the article were misleading. It referred to Kipochi as being able to “convert [Bitcoins] to and from the Kenya currency M-PESA” (Spaven 2013). M-PESA is not a Kenyan currency, but simply a service that allows users to send e-money through an e-money account accessed through the mobile phone. M-PESA is not affiliated with Bitcoin, and there is no integration of the systems. Safaricom does not permit the sale and purchase of Bitcoins using M-PESA. 5 Interestingly, a Silk Road 2.0 website emerged just a month after the shutdown of the original website (Eha 2013). 6 One estimate is that fewer than 1,500 merchants accept Bitcoin globally (Schrade 2013). 7 Hearing “Beyond Silk Road—Potential Threats, Risks, and Promises of Virtual Currency” on 18 November 2013 (statement of Jeremy Allaire), testimony before the Senate Homeland Security and Governmental Affairs Committee, http://www.hsgac.senate.gov/hearings/ beyond-silk-road-potential-risks-threats-and-promises-of-virtual-currencies. Implications for the Unbanked ———. 2013c. “How Do Bitcoin Transactions Work?” 26 November. http://www.coindesk.com/information/how-do- The current realities of Bitcoin mean it is still a long way bitcoin-transactions-work/ January 2014 off from reaching the unbanked. Only the financially Eha, Brian Patrick. 2013. “Could the Silk Road Closure Be included can access the Bitcoin system through the Good for Bitcoin?” The New Yorker, 5 October. http://www. necessary digital connections to the Internet. The newyorker.com/online/blogs/currency/2013/10/could-the-silk- All CGAP publications average transaction size to date is around $2,000. road-closure-be-good-for-bitcoin.html are available on the But as with so many cutting-edge innovations, time CGAP Web site at European Central Bank. 2012. “Virtual Currency Schemes.” www.cgap.org. will tell whether the benefits of Bitcoin can eventually October. http://www.ecb.europa.eu/pub/pdf/other/ impact mainstream populations around the world, CGAP virtualcurrencyschemes201210en.pdf and perhaps even those at the base of the pyramid. 1818 H Street, NW European Commission. 2009. European Commission Electronic Advocates of the virtual currency believe that Bitcoin’s MSN P3-300 Money Directive (2009/110/EC). Washington, DC peer-to-peer architecture and low barriers to entry FATF (Financial Action Task Force). 2013. “FATF’s Guidance 20433 USA will lead to the creation of a generation of innovative financial services, in much the same way as the for a Risk-Based Approach: Prepaid Cards, Mobile Payments Tel: 202-473-9594 Internet’s open architecture led to new online services and Internet-Based Payment Services. http://www.fatf-gafi. Fax: 202-522-3744 (Lee 2013). Proponents argue that Bitcoin provides org/media/fatf/documents/recommendations/Guidance-RBA- a much cheaper and quicker payment system than NPPS.pdf Email: what is currently available, especially for international FinCEN (Financial Crimes Enforcement Network). 2013. cgap@worldbank.org transfers. That may be so, but it is also possible that five “Application of FinCEN’s Regulations to Persons Administering, © CGAP, 2014 years from now Bitcoin will have disappeared or been Exchanging, or Using Virtual Currencies.” 18 March. http:// replaced by other types of virtual or cryptocurrencies. fincen.gov/statutes_regs/guidance/html/FIN-2013-G001.html Hern, Alex. 2013. “Is Bitcoin about to Change the World?” There is more clarity around e-money, with mounting The Guardian, 25 November. http://www.theguardian.com/ evidence that it has brought previously excluded technology/2013/nov/25/is-bitcoin-about-to-change-the- people into the formal financial system. Regulators world-peer-to-peer-cryptocurrency-virtual-wallet?CMP=fb_gu and policy makers should take care not to confuse Hoskinson, Charles. 2013. “The Mathematician’s Defense of e-money with virtual currencies like Bitcoin and, in Bitcoin: It’s Just Another Option.” PBS Newhour, 9 October. so doing, retract on the regulatory progress that has http://www.pbs.org/newshour/businessdesk/2013/10/the- enabled e-money systems to flourish under risk-based mathematicians-defense-of.html proportionate regulation. E-money should continue to be regulated proportionately based on the size Lee, Timothy B. 2013. “12 Questions about Bitcoin You Were and nature of e-money transactions, continuing to Too Embarrassed to Ask.” The Switch blog post. Washington open access to the formal financial system for many Post, 19 November. http://www.washingtonpost.com/blogs/ of the world’s unbanked. the-switch/wp/2013/11/19/12-questions-you-were-too- embarrassed-to-ask-about-bitcoin/ References Mattise, Nathan. 2013. “Amid Silk Road Uncertainty, Bitcoin Value Drops over 20% in 3 Hours.” arstechnica.com, 2 October. Arthur, Charles. 2011. “Bitcoin Value Crashes below Cost of http://arstechnica.com/information-technology/2013/10/amid- Production as Broader Use Stutters.” theguardian.com, 18 silk-road-uncertainty-bitcoin-value-drops-over-20-in-3-hours/ October. http://www.theguardian.com/technology/2011/ Nakamoto, Satoshi. n.d. “Bitcoin: A Peer-to-Peer Electronic oct/18/bitcoin-value-crash-cryptocurrency Cash System.” Bitcoin.org. http://bitcoin.org/bitcoin.pdf Bloomberg News. 2013. “China Bans Financial Companies Schrade, Dirk. 2013. “Virtual Currency Schemes: Bitcoin—A from Bitcoin Transactions.” Bloomberg Personal Finance, Matter of Swim or Sink? Presentation at the Committee on 5 December. http://www.bloomberg.com/news/2013-12- Payment and Settlement Systems World Bank Conference, 05/china-s-pboc-bans-financial-companies-from-bitcoin- Cape Town, 3–4 December. transactions.html Spaven, Emily. 2013. “Kipochi Launches M-Pesa Integrated Brito, Jerry, and Andrea Castillo. 2013. “Bitcoin: A Primer for Bitcoin Wallet in Africa.” CoinDesk, 9 July. http://www. Policymakers.” Mercatus Center: Geroge Mason University. coindesk.com/kipochi-launches-m-pesa-integrated-bitcoin- http://mercatus.org/sites/default/files/Brito_BitcoinPrimer_ wallet-in-africa/ embargoed.pdf Tarazi, Michael, and Paul Breloff. 2010. “Nonbank E-Money CoinDesk. 2013a. “What Is Bitcoin.” 26 November. http:// Issuers: Regulatory Approaches to Protecting Customer www.coindesk.com/information/what-is-bitcoin/ Funds.” Focus Note 63. Washington, D.C.: CGAP, July. ———. 2013b. “How Bitcoin Mining Works.” 26 November. Time Magazine. 2013. “The Deep Web.” Time Magazine, 11 http://www.coindesk.com/information/how-bitcoin-mining- works/ November. AUTHOR: Sarah Rotman