Pub. 9 2014-2015 Issue 1

www.nebankers.org 10 Extraordinary Service for Extraordinary Members. COUNSELOR’S CORNER Bona Fide or Balderdash? Bryan Handlos , Kutak Rock LLP Bitcoins & Banking: C ONSIDERING THE WEIGHT OF MR. Buffett’s view, this could be a very short article. Are there any reasons bankers should spend time thinking about Bitcoin? Short answer: Bankers probably have several more pressing challenges that need attention. Longer answer: There are reasons to consider the impact this technology may have on banks in gen- eral in the medium-term future. What is Bitcoin? Bitcoin is an open-source software system designed to create and manage units of a virtual currency called Bit- coins. Bitcoins have no physical pres- ence and no intrinsic value. They are considered a “cryptocurrency” because the system depends on cryptography. The system is decentralized (has no cen- tral issuing authority) and is designed to allow online payments directly fromone party to another without going through a bank. Bitcoins are created as a reward for entities that use their computers to support the system (“miners”). Creation occurs at a steady rate that decreases over time and will cease when 21 mil- lion Bitcoins have been created some decades from now. Bitcoins can be acquired by “mining” them, purchasing them (e.g., at a Bitcoin exchange), or accepting them as payment. Bitcoin transactions are dependent upon the use of cryptographic public keys and private keys. The private keys must be kept secret. Secrecy can be maintained by storing the private key on paper, on an external storage device, or in a software “wallet.” Like cash, if the security of a bitcoin owner’s private key or wallet is compromised, the owner’s bitcoins can be stolen. Bitcoins also can be lost if the private key is lost. 2 A key feature of Bitcoin technology is a public ledger of all transactions known as the “blockchain.” 3 The blockchain is central to the proper functioning of the Bitcoin network. The blockchain is where miners, by consensus, con- firm transactions by packing them into blocks that fit strict cryptographic rules. This system verifies that bitcoins are actually owned by the spender and prevents double spending. Bitcoin transactions are irreversible. Is Bitcoin legitimate? Because they had some initial popularity in supposedly anonymous transactions to purchase illegal drugs (among other things) at illicit websites like Silk Road (closed by the FBI in 2013), bitcoins have had an air of illegitimacy. Follow- ing the closure of Silk Road, however, the FBI reportedly acknowledged to the Senate Homeland Security and Government Affairs committee that virtual currencies offered “legitimate financial services” although they were obviously subject to abuse. As some mainstream merchants have started to accept bitcoins 4 and as they become the subject of various types of regulatory review, 5 Bitcoin has improved its aura of legitimacy. This question of legitimacy will probably become moot, for Bitcoin or some other virtual currency, the day the biggest online retailers begin to ac- cept it for payment. Doesn’t Bitcoin have a lot of issues? Yes, here is just an introductory sam- pling: (1) Bitcoins have no intrinsic value, no legal backing, and a value that fluctuated substantially compared to the dollar from zero to more than $1,100 (at the time of this writing, they are in the range of $460); 6 (2) Bitcoin is almost entirely unregulated (which may be a virtue to some, 7 is almost cer- tainly not a good thing for consumers, 8 and is not necessarily a great thing for bankers); 9 (3) There appears to be real security and/or management problems at some exchanges—Mt. Gox in Japan is the most noteworthy example (now in bankruptcy, it reportedly lost some $470million in bitcoins), but exchanges in Canada, China, and Palau have also recently been closed and/or have suf- fered losses fromhacking; (4) InMarch of this year, the IRS issued guidance indicating that bitcoins and other vir- tual currencies would be treated like property, meaning, among other things, that payments may result in tax events if the property purchased exceeds the payor’s basis in the bitcoins used (thus creating a number of potentially serious recordkeeping and other issues for pay- ors); and (5) Like any other technology, Bitcoin has competitors and could well fall victim to the next newer and better platform. Why should bankers be interested in Bitcoin or technologies like it? 1. Bitcoin technology is the end of banking as we know it. This may be overstated, but some of Bitcoin’s proponents would like to think otherwise. 10 As a system specifically de- signed to cut banks out of the payment process, this technology obviously does present some level of threat in an area that has historically been dominated by banks. All other things being equal, Bitcoin’s low transaction costs could have obvious appeal to merchants. 11 “Stay away. Bitcoin is a mirage. . . The idea that it has some huge intrinsic value is just a joke in my view.” —Warren Buffett on CNBC, March 14, 2014. 1